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So now the ETF leads the way and shows the real flows. Any chance a dealer had of selling bonds at a high price is pretty much gone. The transparency makes it harder to hide, and brings down offers quickly, making the market seem “heavy” causing bids to pull, and ETF’s to sell off more.

That is risky enough, but the ETF “arb” like index “arb” is what typically creates the next wave of the feedback loop.

While a real bond investor is unlikely to hit the “low” bid, an ETF arb client might. A real investor will see how quickly the bid has dropped and determine what they think is the best course of action. They might not sell here thinking the market has gotten ahead of itself. They might sell something else. They might short the ETF (yes, there is a propensity to short something you don’t own, even if it is “cheap” rather than taking the hit on what you own, I understand it, I’ve done it, but it is unhealthy).

So while traditional bond investors can commiserate with their salespeople over how quickly things gapped down and strategize about how to play it, and traders can try to avoid having long pushed in their mush, there is a group of traders who don’t think like that.

All they need to know, is if they can hit 98 bids on X number of bonds that the ETF’s are looking for, they can hit those bids, buy the ETF, do a redemption, where they exchange ETF’s for the bonds (to get net flat) and take out a profit if the ETF is trading cheap enough.

This group of traders isn’t concerned about the absolute price of the bonds, because they didn’t own them before, and won’t own them again in a few minutes (slight exaggeration). All they care about is the relationship between the bonds and the ETF.

In credit markets, and high yield in particular, this puts the single name risk in the exact wrong hands, at least if you are looking for stability. It means market makers are getting hit on bonds on levels they didn’t think possible, in a falling market. At some point, any hopes of greed and crossing the bonds for some decent coin get replaced by fear. What does someone know? How much is coming out.

Intellectually they might know it is the arb, but they won’t be able to stop themselves from getting some protection such as shorting the ETF. The market maker stops worrying about making and losing eighths and quarters and worries about losing the notional amount. At that moment, they need to get out.

So far we haven’t seen a full feedback loop on the downside in the ETF space. We came close a couple of times, but it never quite seemed to crack. We have seen it on the upside. I would argue that much of the rally in the first part of this year, was because the ETF’s were trading at a premium and the self-fulfilling feedback loop was in play. But on the upside, the fear, even of being short, never hits the same way as the fear of being long. Being short, especially at record prices on bonds, doesn’t have the same danger as being long. So that feedback loop isn’t as dangerous.

On the other hand, if you looked at CDS, we had a big feedback loop this year. We saw it happen with the JPM IG9 trade unwind.

Just a Theory, Not a Warning

I don’t see anything to trigger this loop right now. Europe is doing some things to reduce risk. The Fed is pumping money into the system. I’m not concerned about this occurring anytime soon, but while we have such a quiet day, I figured it was worth explaining, because if and when we get a loop like this on the downside there will be no time to explain.

In the meantime, one reason I’m comfortable being neutral on high yield up here and don’t think there is any urgency to buy is because the premiums of the funds don’t indicate strong demand or that the arb activity will be there to support the feedback loop. I sent out to some people last Wednesday why I thought the CDS market would outperform ETF’s, and that is still my view, and has a lot to do with the bonds that make up the high yield index and their rate risk exposure for some, and horrible convexity for others.